Q6. The reinvestment assumption is less important if the coupon and term to maturity are:

          Coupon                           Q7. Term to Maturity

A)    lower                                    shorter

B)    lower                                    longer

C)    higher                                  shorter

Q7. Which of the following statements relating to reinvestment risk for bonds is TRUE?

A)   Long-term bonds should be purchased if the investor anticipates higher reinvestment rates.

B)   Zero coupon bonds have no reinvestment risk over their term.

C)   Unless the reinvestment rate equals the yield to maturity, the holding period return will be less than the yield to maturity.

Q8. Which of the following statements about balancing reinvestment risk and price risk is TRUE? When interest rates:

A)   rise, price risk decreases and reinvestment risk increases.

B)   rise, price risk increases and reinvestment risk increases.

C)   decline, price risk decreases and reinvestment risk increases.

Q9. Which of the following choices correctly places callable bonds, straight coupon bonds, mortgage-backed securities, and zero-coupon bonds in order from the type of security with the least reinvestment risk to the one with the most reinvestment risk?

A)   zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

B)   zero-coupon bonds, mortgage-backed securities, straight coupon bonds, callable bonds.

C)   callable bonds, straight coupon bonds, zero-coupon bonds, mortgage-backed securities.

Q10. Which of the following statements concerning reinvestment risk is most accurate?

A)   Reinvestment risk is highest for zero-coupon bonds.

B)   Lower coupon bonds have more reinvestment risk.

C)   Reinvestment risk is increased if there are prepayment provisions on the bond.

Q11. Which of the following statements is TRUE?

A)   A bond with high reinvestment risk also has high price, or interest rate risk.

B)   The prepayment option on a mortgage loan benefits the issuer.

C)   Mortgage backed and asset backed securities have lower reinvestment risk than straight coupon bonds.

Q6. The reinvestment assumption is less important if the coupon and term to maturity are:fficeffice" />

          Coupon                           Q7. Term to Maturity

A)    lower                                    shorter

B)    lower                                    longer

C)    higher                                  shorter

Correct answer is A)

This question is asking: when is the risk of a bond investor having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield?  Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. Reinvestment risk is important because the yield-to-maturity (YTM) calculation for a bond assumes that the investor can reinvest cash flows at exactly the coupon rate. (Note: YTM calculations are discussed in a later LOS.)

All else equal, the bond with the shorter term to maturity is less sensitive to changes in interest rates and prepayment rates. Here, this means that a shorter-term bond has lower reinvestment risk than a longer-term bond. 

All else equal, a lower coupon rate means that it is more likely that the investor can reinvest the coupon cash flow at near or equal to the yield-to-maturity. Here, this means that a lower coupon bond has less reinvestment risk.

In summary, reinvestment risk is least important with the combination of shorter maturity and lower coupon rate.

Q7. Which of the following statements relating to reinvestment risk for bonds is TRUE?

A)   Long-term bonds should be purchased if the investor anticipates higher reinvestment rates.

B)   Zero coupon bonds have no reinvestment risk over their term.

C)   Unless the reinvestment rate equals the yield to maturity, the holding period return will be less than the yield to maturity.

Correct answer is B)

This statement is true only if the investor holds the bond until maturity. Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield. Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate bond reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments over the life to reinvest.

The statement, "Long-term bonds should be purchased if the investor anticipates higher reinvestment rates," should read, "Short-term bonds...".If an investor expects interest rates to rise, he would want a bond with a shorter maturity so that he received his cash flows sooner and could reinvest at the higher rate. Also, there is less prepayment risk with shorter maturities.

The statement that begins, "Unless the reinvestment rate...," is partially true. However, the holding period return (covered in a later LOS) could be less or greater than the original yield to maturity (YTM). Over the investor's holding period, interest rates are likely to fluctuate both up and down; at some points the investor will reinvest at a higher rate than the original YTM and sometimes he will reinvest at a lower rate.

Q8. Which of the following statements about balancing reinvestment risk and price risk is TRUE? When interest rates:

A)   rise, price risk decreases and reinvestment risk increases.

B)   rise, price risk increases and reinvestment risk increases.

C)   decline, price risk decreases and reinvestment risk increases.

Correct answer is C)

All else equal, reinvestment risk and price risk move in opposite directions. For example, when interest rates rise, bond prices decrease, but the loss is at least partially offset by decreased reinvestment risk (it is less likely that a bond will be called and bondholders can invest coupon payments at higher yields). When interest rates fall, price risk decreases because the bond value is rising and reinvestment risk increases because it is more likely that the issuer/borrower will call the security and the bondholder must reinvest coupon payments at lower yields.

Q9. Which of the following choices correctly places callable bonds, straight coupon bonds, mortgage-backed securities, and zero-coupon bonds in order from the type of security with the least reinvestment risk to the one with the most reinvestment risk?

A)   zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

B)   zero-coupon bonds, mortgage-backed securities, straight coupon bonds, callable bonds.

C)   callable bonds, straight coupon bonds, zero-coupon bonds, mortgage-backed securities.

Correct answer is A)

Of the three choices, zero-coupon bonds have the least reinvestment risk. An investor can nearly eliminate reinvestment risk by holding a noncallable zero-coupon bond until maturity because zero-coupon bonds deliver all cash flows in one lump sum at maturity.

Straight coupon bonds (no prepayment or other embedded options) have the next most reinvestment risk because of the periodic coupon payments. If interest rates decline, the bondholder will have to reinvest the coupons at a rate lower than that required to earn the original expected yield-to-maturity.

Callable bonds have more reinvestment risk because the right to prepay principal compounds reinvestment risk. A call option is one form of prepayment right that benefits the issuer, or borrower.

Mortgage backed and other asset backed securities have the most prepayment risk because in addition to cash flows from periodic interest payments (bond coupons, for example), these securities have periodic repayment of principal. The lower the interest rate, the higher chance that the loans underlying these assets will repay in full

Q10. Which of the following statements concerning reinvestment risk is most accurate?

A)   Reinvestment risk is highest for zero-coupon bonds.

B)   Lower coupon bonds have more reinvestment risk.

C)   Reinvestment risk is increased if there are prepayment provisions on the bond.

Correct answer is C)

Reinvestment risk is increased if there are prepayment provisions that return a large amount of principal to the lender at a time when interest rates have declined. Note that the other statements are false. Reinvestment risk is lowest for zero coupon bonds – a corollary of this statement is that the lower the coupon, the less reinvestment risk there is for the bond.

Q11. Which of the following statements is TRUE?

A)   A bond with high reinvestment risk also has high price, or interest rate risk.

B)   The prepayment option on a mortgage loan benefits the issuer.

C)   Mortgage backed and asset backed securities have lower reinvestment risk than straight coupon bonds.

Correct answer is B)

In the case of a mortgage or auto loan, the issuer is the borrower and is the party that benefits from the prepayment option. In a declining interest rate environment, the issuer can retire higher cost debt and replace it with lower cost debt (i.e. refinancing a mortgage). When an issuer (borrower) calls, or prepays, the lending institution (the security holder) faces reinvestment risk because it must reinvest the proceeds at lower rates.

Mortgage backed and other asset backed securities have high reinvestment (or prepayment) risk because in addition to cash flows from periodic interest payments (like bond coupons), these securities have repayment of principal. The lower the interest rate, the higher chance that the loans underlying these assets will repay in full due to refinancings. A bond, such as a zero coupon bond, can have high interest rate risk (because its single cash flow subjects it to the full amount of discounting when interest rates change) and low reinvestment risk (the single cash flow minimizes prepayment risk).

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